Fitch said Melstacorp’s rating reflects the group’s strong credit profile, underpinned by its entrenched market position in Sri Lanka’s alcoholic-beverage sector and the high entry barriers, which drive its strong operating cash flows and low leverage, and offset the weaknesses in its other, less operationally significant, investments.

Melstacorp’s rating also factors in its controlling stake in Sri Lanka-based conglomerate Aitken Spence PLC (ASP), which has leading market positions in leisure, logistics and power generation.

“We proportionately consolidate ASP’s financials with that of Melstacorp in arriving at the rating to reflect our view that Melstacorp’s access to ASP’s cash balances and future cash flows will be limited to its effective ownership of 51%,” Fitch Ratings said.

“We also believe that Melstacorp will only likely provide its proportionate share of support to ASP, if required, due to the subsidiary’s large public ownership.”

KEY RATING DRIVERS

Leading Alcoholic-Beverage Maker: Melstacorp’s 92.5%-owned subsidiary, Distilleries Company of Sri Lanka (DIST: AAA(lka)/Stable), accounts for over 60% of Sri Lanka’s spirits production and has been able to maintain its market leadership due to its entrenched DCSL brand and access to a country-wide distribution network. The complete advertising ban on alcoholic beverages acts as a high entry barrier and further strengthens DIST’s dominance. However, spirits makers’ volumes are likely to drop after the government revised excise duties to tax the manufacturers at higher rates than beer and wine makers from November 2017.

We expect DIST’s volumes to remain flat in the financial year ending March 2019 (FY19) as its strong market position will offset the tax policy and revenue to grow by low-single digits thereafter as it passes on higher input costs.

Melstacorp’s consolidated earnings will continue to be underpinned by its alcoholic-beverage sector, which we expect to account for more than 65% of the proportionately consolidated EBITDA of the combined group in the medium term.

Alcoholic Beverages Boost State Revenue: We expect the alcoholic-beverage sector’s importance to government revenue to reduce the risk the government will hobble the industry. Incremental excise tax increases on spirits will likely be slow as prices beyond consumer affordability could lower the government’s income. Excise taxes on liquor contributed an estimated 7% to government tax revenue in 2017, with DIST accounting for around half of this amount.

ASP Improves Business Risks: We believe the combined credit profile of Melstacorp and ASP is among the top tier of Sri Lankan corporates for credit quality. We have assessed ASP’s standalone credit profile to be weaker than that of Melstacorp (without ASP) due to the subsidiary’s exposure to segments with more volatile cash flows such as leisure, tea and oil-palm plantations, and its slightly higher leverage (2.5x in FY18). This is offset by the greater diversification of Melstacorp’s earnings and larger operating scale as a result of the combination. We estimate ASP will contribute around 30% to the group’s EBITDA from FY19.

Margin to Improve: We expect the group’s EBITDAR margin to rise by around 120bp in FY19 (FY18: 22.4%) as we forecast DIST’s standalone EBITDAR margin will recover to around 33% from FY19 due to better sourcing strategies.

DIST’s EBITDAR margin rose to 31.4% in 1QFY19, after falling to 28.6% in FY18 (FY15-FY17 average: 39%) due to higher costs as a result of a doubling of import duty on ethanol – a key input – in 2016. We also believe DIST will be able to pass on higher costs as we do not foresee a significant increase in excise duty levied on spirits over the next 12-18 months.

Leverage to Peak in FY19: We expect Melstacorp’s leverage, including its 51% share of ASP’s net debt and EBITDA, to peak at 1.5x in FY19 (FY18 and last 12 months to 1Q19: 1.3x) mainly due to large capex plans at ASP’s power and leisure segments and Melstacorp’s possible expansion into the healthcare sector. Leverage is also high at the group’s telecom subsidiary, Lanka Bell Limited, and plantation subsidiaries. We expect Lanka Bell to continue incurring high capex as it expands its 4G coverage. Volatile tea and rubber prices continue to affect the group’s plantation business, although revenue improved in FY18.

Acquisitive Nature – Event Risk: We believe Melstacorp will increase its focus on acquisitions in non-alcoholic beverage segments. Melstacorp sold its investment in a fully owned licensed finance company, Melsta Regal Finance Limited, in March 2018 while it increased its stake in its plantation-sector assets in September 2017. The group has historically pursued acquisitions actively and its latest focus is on the healthcare sector but the company has yet to announce a confirmed strategy. Melstacorp’s rating could come under pressure if there are significant debt-funded acquisitions, particularly those that weaken the group’s overall business risk and increase its cash flow volatility.

DERIVATION SUMMARY

Melstacorp is a leading conglomerate in Sri Lanka with exposure to sectors such as alcoholic beverages, plantations, telecom, leisure, power and logistics. Melstacorp’s core subsidiary, DIST, is Sri Lanka’s leading alcoholic-beverage manufacturer, with a strong portfolio of well-known brands and access to an extensive distribution network.

Melstacorp’s similarly rated peers, Sri Lanka Telecom PLC (AAA(lka)/Stable) and Dialog Axiata PLC (AAA(lka)/Stable) enjoy a larger operating scale, reflecting the size of the local telecom market and the companies’ market leadership in fixed line and mobile, respectively. Melstacorp’s operations, though more diversified, are smaller in scale because a significant portion of the country’s alcoholic-beverage consumption occurs outside the formal sector, which is not recorded.

Melstacorp is also exposed to more regulatory risk in its alcoholic-beverage business in the form of regular increases in indirect taxes. But this risk is counterbalanced by its entrenched market position and high entry barriers, which allow the company to pass on cost inflation and maintain margins, supporting substantially stronger free cash flows (FCF) than the telcos. Melstacorp’s capex as a proportion of revenue is also considerably lower than the telcos, and most of Melstacorp’s investments in other businesses are discretionary. The telcos have higher capex intensity due to the need to continually upgrade infrastructure and keep abreast of evolving technology, and to service growing network traffic, resulting in larger and more sustained negative FCF than Melstacorp.

KEY ASSUMPTIONS

Fitch’s Key Assumptions Within Our Rating Case for the Issuer
– Consolidated revenues to grow by mid-single digits in the next two years
– Consolidated EBITDAR margin to improve closer to 24% in FY19 on the back of expanding alcoholic-beverage segment margins (FY18: 22.4%).
– Smaller excise-tax hikes as the government would be mindful of falling revenue collection if demand were to decline.
– Capex to peak at LKR13 billion in FY19, mainly on account of power and leisure segment-related capex by ASP
– A group dividend payout of 30% of net profit over FY19-FY21

RATING SENSITIVITIES

Developments that May, Individually or Collectively, Lead to Positive Rating Action
– There is no scope for an upgrade since the company is at the highest rating on the Sri Lankan National Rating scale.
Developments that May, Individually or Collectively, Lead to Negative Rating Action
– Consolidated financial leverage (measured as adjusted net debt/EBITDAR excluding Continental Insurance Lanka Limited and 51% consolidation of ASP) increasing to over 2.0x on a sustained basis. (FY18: 1.3x)
– A structural change in the domestic alcoholic-beverage industry that considerably weakens DIST’s competitive position.
– A material dilution of Melstacorp’s ownership in DIST, which could reduce Melstacorp’s access to the stable flows generated by its alcoholic-beverage business.

LIQUIDITY

Comfortable Liquidity Position: The group had a comfortable liquidity position at end-March 2018, with LKR19 billion of unutilised but committed credit lines and LKR15 billion of unrestricted cash available to meet LKR19 billion of debt maturing in the next 12 months. We expect Melstacorp to generate around LKR5 billion of negative FCF in FY19 amid higher capex at ASP. The group has strong access to local banks due to its position as one of Sri Lanka’s largest corporates and its solid credit profile.

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